End of an era for consumer goods firms

Tuesday, March 02, 2010

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Pressure will now be on smaller firms to show they can hold their own. Midsize firms found it difficult to compete with the big firms on advertising spending and distribution breadth, where financial muscle mattered.

The end of tax concessions after March for Himachal Pradesh and Uttarakhand marks the end of a golden era for so-called fast-moving consumer goods (FMCG) companies.

Tax concessions for Jammu and Kashmir will come to an end in 2012. Consumer non-durables companies, especially midsize ones, were among the first to seize the opportunity that presented itself in 2002 and 2003. A 10-year excise holiday and a five-year income-tax holiday were announced for companies setting up units in Jammu and Kashmir, Himachal Pradesh and Uttarakhand.

Financial logic won over the challenges posed by poor connectivity and infrastructure, inclement weather, lack of skilled workers and the difficulty of doing business in landlocked locations. It isn’t difficult to see why. Excise duties were at 16% or even more and income tax levied at about 30%. Consider a product with a selling price of Rs100, excise at Rs10 (levied on production cost) and profit before tax at Rs20, and tax of Rs6. By setting up base in these states, a company could save Rs16, an additional 16% profit margin.

Midsize firms such as Dabur India Ltd, Godrej Consumer Products Ltd (GCPL) and Marico Ltd were the first to seize this opportunity. The bigger players, mostly multinational companies, were hesitant initially. Uprooting production bases for tax benefits was not their style. But eventually all of them, including companies such as Hindustan Unilever Ltd (HUL), Nestle India Ltd and Colgate-Palmolive (India) Ltd, moved part of their production to these locations.

Between fiscal 2004 and fiscal 2009, HUL’s excise to gross domestic sales ratio declined from 9.7% to 7.5%, Nestle’s from 6.2% to 3.6%, GCPL from 10.4% to 3.7% and Dabur from 5.9% to 1.2%.

Midsize firms capitalized on this policy the most. These firms found it difficult to compete with the big firms on advertising spending and distribution breadth, where financial muscle mattered. But this policy changed that. Instead of keeping all the profits, they reinvested a significant part in advertising, new products and distribution. Thus, even as sales grew, profit growth kept pace.

Some of their good fortune was due to higher disposable incomes and demographic change. This period coincided with the stock market boom that started in 2004. They used their improved cash flows and improved valuations to buy Indian and foreign assets.

Now, firms need to plan for life after the tax concessions lapse. The immediate impact will be on new projects.

Running factories will continue to get benefits for the predefined period. Eventually, however, profit margins and tax rates will return to normal. That would mean lower margins. The ability of firms to manage this transition would be critical. By then, the goods and services tax should be in place, which is expected to benefit consumer firms. Today, midsize firms are much larger, with a geographically diversified revenue base. Still, India remains a key market. The changed policy will affect all firms, but the pressure will be on smaller companies to show they can hold their own against the big ones, even without tax sops.